S & P Dow Jones Indices on Thursday released its mid-year 2023 SPIVA (S & P Indices Versus Active) Scorecard. This is semi-annual study tracks how active fund managers are performing against their benchmarks and is considered the gold standard to measure active performance. The bottom line: it's tough being an active manager any year, but especially in 2023. Tiny group of outperformers is a problem Call it the Magnificent Seven Problem: we all know that a small group of stocks (Apple, Microsoft, Alphabet, Nvidia, Tesla, Meta, Amazon) were responsible for most of the gains in the S & P this year. But it wasn't just the Magnificent Seven alone: the top 10% of the S & P 500 (the 50 largest stocks) blew away the performance of the other 90%: S & P 500 performance by decile (First six months of 2023) Top 50 +21% 51-100 + 6% 101-150 + 7% 151-200 + 8% 201-250 + 9% 251-300 +10% 301-350 + 4% 351-400 + 9% 401-450 + 6% 451-500 - 3% Source: S & P Dow Jones Indices The outperformance of this small group of tech stocks made it exceptionally difficult for active managers: 60% of large-cap fund managers underperformed the S & P 500 in the first half, not far from the historic average of about 64% underperformance. Why is that? The game for active managers is to outperform the market. When there is a small concentration of big movers, active managers would have to pick those few stocks that outperformed and have an even higher concentration in them to outperform. But when few stocks lead the gains it is difficult (almost impossible) to pick those few winners, and at any rate active managers are reluctant to take such concentrated bets. The other problem is fund managers have to take profits, and they tend to sell winners too early and hold on to losers too long. "This is an extraordinary period: you had a very small number of stocks that did very well," Craig Lazzara, the author of the report, told me. "If you took profits in any of these names, you took them too early, even though I understand why some managers need to do that." A few bright spots for active managers There were a few bright spots: managers of smaller cap funds did a bit better. Only 48% of mid-cap managers lagged the S & P MidCap 400, and only 28% of small-cap managers lagged the S & P SmallCap 600. Why? Lazzara noted that both mid-cap and small-cap sectors underperformed the S & P 500. Small cap managers may have noticed that larger cap stocks were doing well. "If you let average capitalization drift up by owning the bigger companies in a large-cap rally, you may do better," he told me. In fixed income, a majority of active managers outperformed in municipal and some investment grade categories. But most government funds lagged their benchmarks. Reversion to the mean is very real Think you can consistently pick winners and losers? Historically, over time, lower market capitalization stocks have tended to do better. But as you can see in the list above, this was reversed this year. The biggest stocks killed everything else. Here's another trend that should make stock pickers humble: the worst performing sectors last year were consumer discretionary, technology and communication services. The best performing sectors this year are consumer discretionary, technology and communication services. Underperformance is part of a long-term trend The underperformance of active managers is not new. It has been going on for decades. The longer the time horizon, the worst the performance gets. After 1 year, 61% of large cap managers underperform the S & P 500, and it only gets worse from there. Performance of large-cap fund managers (% that underperform the S & P 500) 1 year 61% 5 years 87% 10 years 86% 15 years 92% What this means: after 5 years, almost 90% of active fund managers underperform the market. An important point about the SPIVA study: it accounts for both fees and survivorship bias. Many funds liquidate or merge over time.Over a ten-year period, about one-third of funds go out of business, largely due to poor performance, but the SPIVA report accounts for those funds. Long-term active management is a fundamental problem The problems active managers confront are not temporary. Lazzara noted the primary reasons active managers underperform: 1) The market is largely professionalized; investors, whether professional or retail, do not have an information advantage; 2) The fees of active managers are higher than index fees; 3) In any given year, only a minority of stocks will typically outperform the markets, and it is difficult (almost impossible) to select what stocks will outperform. "If the majority of stocks underperform, and they do, it is hard to pick winners," Lazzara told me.